When Venezuela seized billions of dollars in assets from Exxon Mobil and other foreign companies, Chinese state banks and investors didn’t blink. Over the past five years they have loaned Venezuela more than $35 billion.
Elsewhere around the Caribbean, as hotels were struggling to stay afloat in the global economic slowdown, the Chinese response was to bankroll the biggest resort under construction in the Western Hemisphere — a massive hotel, condominium and casino complex in the Bahamas just a few miles from half-empty resorts.
All over the world, from Latin America to the South Pacific, a cash-flush China is funding projects that others won’t, seemingly less concerned by the conventional wisdom of credit ratings and institutions such as the World Bank.
The Chinese money is breathing life into government infrastructure projects that otherwise might have died for lack of financing. For commercial projects such as the Caribbean resort, China is filling a gap left by Western investors retrenching after the 2008 financial crisis.
But some in the Bahamas worry what will happen if the sprawling Baha Mar project fails. They picture an economy saturated with hotels, dragged down by an expensive Chinese white elephant. Likewise, the infrastructure loans are loading financially shaky countries with more debt and letting them avoid economic reforms that other lenders would likely have demanded.
“The Chinese play by other rules,” said Kevin Gallagher, a Boston University international relations professor who has studied Chinese lending to Latin America. “We’ll give you financing with no conditions, and we’ll finance things the International Monetary Fund won’t fund, things others won’t fund anymore, like big infrastructure projects. It allows countries to shop around, which has good and bad sides.”
Venezuelan leader Hugo Chavez talked up his independence last year while highlighting another $4 billion in Chinese loans, part of a wave of money that has translated into new railways, utilities and other projects.
“In a few days, they’re going to deposit 4 billion little dollars more from Beijing,” Chavez told reporters, holding up four fingers for emphasis.
“Fortunately, we don’t depend on the dreadful bank. What’s that one called that you mentioned? The World Bank. Poor are those countries that depend on the World Bank, the International Monetary Fund.”
Venezuela’s Oil and Mining Minister Rafael Ramirez says China has loaned his country $36 billion since 2008, and others put the figure even higher. The Spanish-language version of a report co-authored by Gallagher, “The New Banks in Town: Chinese Finance in Latin America,” estimates it at $46.5 billion.
The loans have added to Venezuela’s $95.7 billion in public foreign debt as of mid-2012, which has risen even as the country rakes in record-high oil revenue. Some analysts say the spending helped Chavez win re-election in October, despite battling cancer.
China has emerged in recent years as the largest provider of development loans not only to Venezuela but also to Ecuador and Argentina, according to the Gallagher report. All three are junk bond countries, ratings agencies say. In contrast, the World Bank and Inter-American Development Bank remain larger lenders in Brazil and Mexico, both countries with higher bond ratings.
In cases such as the tiny South Pacific islands of Tonga, China is lending enormous sums to countries few expect will be able to repay.
What has surely given the Chinese banks courage is the trillions of dollars in reserves the country holds in U.S. Treasury bonds, investments that pay almost nothing in interest. Making that money work harder for a return overseas has become nothing less than a national priority, part of China’s trumpeted “going out” strategy.
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China’s economy is the second largest after the U.S., and many of the deals stipulate repayment in oil and natural gas, locking in the commodities China will need to sustain its growth for decades to come.
In 2009 and 2010 alone, the China Development Bank extended $65 billion in such loans to energy companies and government entities from Ecuador to Russia and Turkmenistan, according to a report by Erica Downs, a China expert at the Brookings Institution, a U.S. think tank.
“If you’re lending tens of billions of dollars to a borrower …, you want to make sure that loan is secured against something,” she said. “In the case of Venezuela, it’s the most valuable thing they can offer. It’s just one way to ensure they get paid.”
In dozens of cases, the Chinese have also demanded that their own companies build the infrastructure that will help governments extract and ship the commodities used to pay back the loans. In Argentina, that means agreements to bring in Chinese companies to revamp the country’s decrepit rail system, which would speed up shipments of soy to Chinese consumers.
“The money goes from one account in the China Development Bank into the hands of small- and medium-sized businesses in China,” Gallagher said, while noting the majority involve big state companies.
The Chinese also hold a valuable trump card: They’re betting that Chavez and other financial pariahs won’t dare alienate their last source of affordable money by defaulting on Chinese loans or seizing Chinese assets.
“The Chinese have the upper hand,” Downs said. “The China Development Bank sees this country that’s thumbed their nose at the IMF. And if they borrowed from the IMF and had to be subjected to IMF conditionality, the regime would fall.”
Perhaps with that in mind, more than 30 Chinese consultants toured Venezuela in 2011 and handed Chavez a thick binder with recommendations on everything from exchange rate reform to agriculture.
While news cameras clicked, Chavez held up the book, thanked his Chinese benefactors and pledged to study the prescriptions. Unlike IMF loans, however, the Chinese recommendations weren’t a requirement, and Chavez has shown no sign of curbing public spending.
The investments and loans have contributed to a substantial shift in commerce toward China. Venezuela, for example, saw its trade with the U.S. drop from 26 percent of its GDP in 2006 to 18 percent in 2011, according to an Associated Press analysis of IMF databases. Meanwhile, Chinese trade grew from virtually nothing in 2001 to nearly 6 percent a decade later, much of it in the form of oil to repay loans.
But the money doesn’t necessarily save countries from their own bad financial bets.
Zimbabwe, which has received generous Chinese financing, saw inflation peak at 79.6 billion percent a month in November 2008. At one point, a loaf of bread reportedly cost 500 million Zimbabwe dollars. Gideon Gono, governor of the Reserve Bank of Zimbabwe, suggested one possible remedy: Adopt the Chinese yuan as the official currency. (Zimbabwe eventually overcame the crisis by switching to a mix of Western and African currencies.)
Argentina is fighting off an economic reckoning despite receiving more than $12 billion in Chinese loans, according to the Gallagher report. In 2001, the country defaulted on some $100 billion in loans. It struck a deal with most of its lenders, but over the past year, a group of creditors is insisting on payment in full.
“It’s extremely concerning,” said Margaret Meyers, a China expert at the U.S. think tank the Inter-American Dialogue. “Chinese financing won’t be able to sustain these economies unless they go through substantial macroeconomic reforms. For Argentina, that means open markets, reforming institutions, reforming the banking system, fiscal accountability, ending lots of misspending.”
Some in the borrowing countries have watched with worry as the Chinese bets play out.
Opposition politicians in Venezuela have slammed the deals for locking in contracts for everything from Chinese-made refrigerators to Chinese construction workers while giving Chavez free rein to spend billions of dollars.
“There’s no doubt we’re going to need China, they are an economic powerhouse,” opposition leader Henrique Capriles said last year. “But many of the agreements the government has signed involve political loyalties that don’t interest us.”
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On the beaches of New Providence in the Bahamas, hundreds of Chinese construction workers are toiling around the clock to ready the Baha Mar project for a scheduled grand opening in late 2014.
The project will add thousands of hotel rooms not far from the islands’ biggest resort, the Atlantis.
“Going forward, we have to achieve a sustainable tourism product,” said James Smith, the former state minister of finance for the Bahamas. “If we don’t, Baha Mar could be cannibalizing Atlantis.”
Baha Mar has opened sales offices all over Asia to promote and presell hundreds of pricey condos, hoping to imprint new travel habits on a continent that’s traditionally spent beach vacations in Southeast Asia. It is also working with the Bahamian government to open more consular offices in China to issue visas.
“In general, you would assume that a project of that size is generating its own demand and the idea would probably also be with Chinese money comes an influx of Chinese travelers,” said Jan Freitag, senior vice president of hospitality industry research firm STR. “The Chinese would argue that we can maybe attract a clientele that has not been with you before.”
When completed, the complex is set to boast brands such as the Grand Hyatt, Rosewood and Mondrian, and 313 $1-million condos being marketed to the international elite.
Business leaders have openly questioned the investment as Baha Mar rises just blocks from storefronts left empty during the latest downturn. The Wyndham hotel was closed for all of September and most of October because of low occupancy levels, and on Feb. 8 announced the need for “substantial cutbacks,” including layoffs.
“In a vibrant economy, we wouldn’t be having any concerns. The reason it comes into question is whether it’s right at this time,” said Winston Rolle, CEO of the Bahamas’ Chamber of Commerce.
The project had, in fact, been conceived in a different moment, more than six years ago, when the U.S. housing boom and global tourism seemed unstoppable.
One of the original developers, Caesar’s Entertainment Corp., formerly Harrah’s Entertainment, backed out of the project in 2008, and Chinese financiers stepped in after reaching a deal with project CEO Sarkis Izmirlian. The agreement brought in a state-owned Chinese construction company to build the resort.
“This project is essential to developing business in the Caribbean and into the U.S.,” said Tiger Wu, vice president of the construction company, to Bahamian media. “It’s only the beginning.”
All evidence indicates the Chinese are charging forward. They’ve made their $3.5 billion gamble in the Bahamas. Elsewhere, they’ve promised tens of billions of dollars for everything from dams to railroads. Guyana has hired the state-owned Shanghai Construction Group to build a 197-room Marriott Hotel on the southern edge of the Caribbean.
Meanwhile, traditional investors in the U.S. and Europe have been left on the sidelines. It’s China’s game now. And the rest of the world is waiting to see how the big gambles pay off.

Most countries worry about brain drain. China is worried about millionaire drain.

A new report in China shows that 150,000 Chinese – most of them wealthy – emigrated to other countries in 2011. While that number may not seem high for a country of more than a billion people, the flight of China’s richest – and the offshoring of their fortunes – could cost the country jobs and economic growth, according to the study from the Center for China and Globalization and the Beijing Institute of Technology.

“The private economy contributes more than 60 percent of China’s GDP and it absorbs a majority of employees. So if private business owners emigrate with their capital, it would mean less investment in the domestic market, so fewer jobs would be created,” Wang Huiyao, director of the Center for China and Globalization, told the state-run China Daily today.

The fleeing millionaires mainly made their money in real estate, foreign currency and deposits and stocks, among other fields, according to the report. They are mainly leaving Beijing, Shanghai and coastal provinces such as Zhejiang, Guangdong and Jiangsu. (Read more: BRICs Outpace U.S. in Millionaires)

The Chinese government has struggled to stem the tide of wealthy Chinese moving abroad or tunneling their fortunes out of the country. Last month, Zhang Lan – the founder of the South Beauty restaurant chain and a powerful political player – emigrated to an unknown foreign country. She had previously been an outspoken critic of rich Chinese who moved abroad.

When asked about her reasons for moving, her spokesman told China Daily, “It’s a private issue.”

Officially, Chinese individuals are allowed to move only $50,000 offshore every year. But many Chinese have been skirting the rules and moving money to overseas accounts, or buying property, art, wine and other assets overseas.

The Wall Street Journal recently estimated that more than $225 billion flowed out of China in the 12 months ended in September. (Read more: What Do Wealthy Chinese Women Want?)

The report on emigration said that for Chinese moving abroad, the main reasons cited for leaving are the security of their assets, improved quality of life and better education for their kids.

China’s wealth flight, however, has been America’s gain. The United States was the top destination for wealthy Chinese in 2011, according to the report. Canada and Australia came second and third.

The report said that the United States had granted 87,000 permanent resident permits to Chinese nationals in 2011. Of those, 3,340 were approved through special investment visas, which allows wealthy foreigners to apply for American citizenship if they agree to invest more than $500,000 on job-creation projects. The program has become largely Chinese, with more than more than two thirds of all of the visas granted going wealthy citizens of mainland.

Last year, for the first time, more patent applications were filed in China than in the United States. This surge reflects China’s increasing intellectual property maturity and growing pains, according to U.S. Intellectual property lawyers and experts.

Worldwide patent filings exceeded the 2 million mark, with 2.14 million filed last year. That’s a 7.8 percent boost over the 1.99 million applications filed in 2010.

“Sustained growth in IP filings indicates that companies continue to innovate despite weak economic conditions. This is good news, as it lays the foundation for the world economy to generate growth and prosperity in the future,” said WIPO director general Francis Gurry at a press conference in Geneva.

The numbers reflect a boost in innovation by Chinese nationals, said Stuart Meyer, an intellectual property partner at Fenwick & West in Mountain View, Calif. It’s not just U.S. inventors wanting to get protection in China because it’s commercially important, he said. “That’s a real sea change.”

Ultimately, such filing shifts could affect U.S. patent policy, which offers great protections for intellectual property producers, he said.

The balance is shifting a little bit because more U.S. companies are dealing with licensing intellectual property owned by foreign patentees, said Meyer. “We’re the ones that don’t need such rigorous protection because we’re on the other side of the coin. It changes the way we’re going to be thinking about this in the coming decades.”

The numbers are a milestone in the way innovation is distributed around the world, said Q. Todd Dickinson, executive director of the American Intellectual Property Law Association. “Clearly china is in growth mode in terms of research and development and patent filings track that closely.”

He also said China’s intellectual property system is maturing. “Clearly they’re using IP to protect indigenous innovation.”

The filings show that everyone wants to do business in China, but China also needs to improve patent enforcement, said Peter Toren, a partner at Weisbrod Matteis & Copley in Washington.

“I’ll be more impressed when I get the real sense that China is enforcing patent rights…I want to see them allowing companies to really enforce the rights they have,” Toren said.

Dynamic domestic players and focused multinationals are helping China churn out a growing number of innovative products and services. Intensifying competition lies ahead; here’s a road map for navigating it.

MCKINSEY QUARTERLY FEBRUARY 2012 • Gordon Orr and Erik Roth

China is innovating. Some of its achievements are visible: a doubling of the global percentage of patents granted to Chinese inventors since 2005, for example, and the growing role of Chinese companies in the wind- and solar-power industries. Other developments—such as advances by local companies in domestically oriented consumer electronics, instant messaging, and online gaming—may well be escaping the notice of executives who aren’t on the ground in China.

As innovation gains steam there, the stakes are rising for domestic and multinational companies alike. Prowess in innovation will not only become an increasingly important differentiator inside China but should also yield ideas and products that become serious competitors on the international stage.

Chinese companies and multinationals bring different strengths and weaknesses to this competition. The Chinese have traditionally had a bias toward innovation through commercialization—they are more comfortable than many Western companies are with putting a new product or service into the market quickly and improving its performance through subsequent generations. It is common for products to launch in a fraction of the time that it would take in more developed markets. While the quality of these early versions may be variable, subsequent ones improve rapidly.1

Chinese companies also benefit from their government’s emphasis on indigenous innovation, underlined in the latest five-year plan. Chinese authorities view innovation as critical both to the domestic economy’s long-term health and to the global competitiveness of Chinese companies. China has already created the seeds of 22 Silicon Valley–like innovation hubs within the life sciences and biotech industries. In semiconductors, the government has been consolidating innovation clusters to create centers of manufacturing excellence.

But progress isn’t uniform across industries, and innovation capabilities vary significantly: several basic skills are at best nascent within a typical Chinese enterprise. Pain points include an absence of advanced techniques for understanding—analytically, not just intuitively—what customers really want, corporate cultures that don’t support risk taking, and a scarcity of the sort of internal collaboration that’s essential for developing new ideas.

Multinationals are far stronger in these areas but face other challenges, such as high attrition among talented Chinese nationals that can slow efforts to create local innovation centers. Indeed, the contrasting capabilities of domestic and multinational players, along with the still-unsettled state of intellectual-property protection (see sidebar, “Improving the patent process”), create the potential for topsy-turvy competition, creative partnerships, and rapid change. This article seeks to lay out the current landscape for would-be innovators and to describe some of the priorities for domestic and multinational companies that hope to thrive in it.

China’s innovation landscape

Considerable innovation is occurring in China in both the business-to-consumer and business-to-business sectors. Although breakthroughs in either space generally go unrecognized by the broader global public, many multinational B2B competitors are acutely aware of the innovative strides the Chinese are making in sectors such as communications equipment and alternative energy. Interestingly, even as multinationals struggle to cope with Chinese innovation in some areas, they seem to be holding their own in others.

The business-to-consumer visibility gap

When European and US consumers think about what China makes, they reflexively turn to basic items such as textiles and toys, not necessarily the most innovative products and rarely associated with brand names.

In fact, though, much product innovation in China stays there. A visit to a shop of the Suning Appliance chain, the large Chinese consumer electronics retailer, is telling. There, you might find an Android-enabled television complete with an integrated Internet-browsing capability and preloaded apps that take users straight to some of the most popular Chinese Web sites and digital movie-streaming services. Even the picture quality and industrial design are comparable to those of high-end televisions from South Korean competitors.

We observe the same home-grown innovation in business models. Look, for example, at the online sector, especially Tencent’s QQ instant-messaging service and the Sina Corporation’s microblog, Weibo. These models, unique to China, are generating revenue and growing in ways that have not been duplicated anywhere in the world. QQ’s low, flat-rate pricing and active marketplace for online games generate tremendous value from hundreds of millions of Chinese users.

What’s keeping innovative products and business models confined to China? In general, its market is so large that domestic companies have little incentive to adapt successful products for sale abroad. In many cases, the skills and capabilities of these companies are oriented toward the domestic market, so even if they want to expand globally, they face high hurdles. Many senior executives, for example, are uncomfortable doing business outside their own geography and language. Furthermore, the success of many Chinese models depends on local resources—for example, lower-cost labor, inexpensive land, and access to capital or intellectual property—that are difficult to replicate elsewhere. Take the case of mobile handsets: most Chinese manufacturers would be subject to significant intellectual property–driven licensing fees if they sold their products outside China.

Successes in business to business

Several Chinese B2B sectors are establishing a track record of innovation domestically and globally. The Chinese communications equipment industry, for instance, is a peer of developed-world companies in quality. Market acceptance has expanded well beyond the historical presence in emerging markets to include Europe’s most demanding customers, such as France Télécom and Vodafone.

Pharmaceuticals are another area where China has made big strides. In the 1980s and 1990s, the country was a bit player in the discovery of new chemical entities. By the next decade, however, China’s sophistication had grown dramatically. More than 20 chemical compounds discovered and developed in China are currently undergoing clinical trials.

China’s solar- and wind-power industries are also taking center stage. The country will become the world’s largest market for renewable-energy technology, and it already has some of the sector’s biggest companies, providing critical components for the industry globally. Chinese companies not only enjoy scale advantages but also, in the case of solar, use new manufacturing techniques to improve the efficiency of solar panels.

Success in B2B innovation has benefited greatly from friendly government policies, such as establishing market access barriers; influencing the nature of cross-border collaborations by setting intellectual-property requirements in electric vehicles, high-speed trains, and other segments; and creating domestic-purchasing policies that favor Chinese-made goods and services. Many view these policies as loading the dice in favor of Chinese companies, but multinationals should be prepared for their continued enforcement.

Despite recent setbacks, an interesting example of how the Chinese government has moved to build an industry comes from high-speed rail. Before 2004, China’s efforts to develop it had limited success. Since then, a mix of two policies—encouraging technology transfer from multinationals (in return for market access) and a coordinated R&D-investment effort—has helped China Railways’ high-speed trains to dominate the local industry. The multinationals’ revenue in this sector has remained largely unchanged since the early 2000s.

But it is too simplistic to claim that government support is the only reason China has had some B2B success. The strength of the country’s scientific and technical talent is growing, and local companies increasingly bring real capabilities to the table. What’s more, a number of government-supported innovation efforts have not been successful. Some notable examples include attempts to develop an indigenous 3G telecommunications protocol called TDS-CDMA and to replace the global Wi-Fi standard with a China-only Internet security protocol, WAPI.

Advantage, multinationals?

Simultaneously, multinationals have been shaping China’s innovation landscape by leveraging global assets. Consider, for example, the joint venture between General Motors and the Shanghai Automotive Industry Corporation, which adapted a US minivan (Buick’s GL8) for use in the Chinese market and more recently introduced a version developed in China, for China. The model has proved hugely popular among executives.

In fact, the market for vehicles powered by internal-combustion engines remains dominated by multinationals, despite significant incentives and encouragement from the Chinese government, which had hoped that some domestic automakers would emerge as leaders by now. The continued strength of multinationals indicates how hard it is to break through in industries with 40 or 50 years of intellectual capital. Transferring the skills needed to design and manufacture complex engineering systems has proved a significant challenge requiring mentorship, the right culture, and time.

We are seeing the emergence of similar challenges in electric vehicles, where early indications suggest that the balance is swinging toward the multinationals because of superior product quality. By relying less on purely indigenous innovation, China is trying to make sure the electric-vehicle story has an ending different from that of its telecommunications protocol efforts. The government’s stated aspiration of having more than five million plug-in hybrid and battery electric vehicles on the road by 2020 is heavily supported by a mix of extensive subsidies and tax incentives for local companies, combined with strict market access rules for foreign companies and the creation of new revenue pools through government and public fleet-purchase programs. But the subsidies and incentives may not be enough to overcome the technical challenges of learning to build these vehicles, particularly if multinationals decline to invest with local companies.

Four priorities for innovators in China

There’s no magic formula for innovation—and that goes doubly for China, where the challenges and opportunities facing domestic and multinational players are so different. Some of the priorities we describe here, such as instilling a culture of risk taking and learning, are more pressing for Chinese companies. Others, such as retaining local talent, may be harder for multinationals. Collectively, these priorities include some of the critical variables that will influence which companies lead China’s innovation revolution and how far it goes.

Deeply understanding Chinese customers

Alibaba’s Web-based trading platform, Taobao, is a great example of a product that emerged from deep insights into how customers were underserved and their inability to connect with suppliers, as well as a sophisticated understanding of the Chinese banking system. This dominant marketplace enables thousands of Chinese manufacturers to find and transact with potential customers directly. What looks like a straightforward eBay-like trading platform actually embeds numerous significant innovations to support these transactions, such as an ability to facilitate electronic fund transfers and to account for idiosyncrasies in the national banking system. Taobao wouldn’t have happened without Alibaba’s deep, analytically driven understanding of customers.

Few Chinese companies have the systematic ability to develop a deep understanding of customers’ problems. Domestic players have traditionally had a manufacturing-led focus on reapplying existing business models to deliver products for fast-growing markets. These “push” models will find it increasingly hard to unlock pockets of profitable growth. Shifting from delivery to creation requires more local research and development, as well as the nurturing of more market-driven organizations that can combine insights into detailed Chinese customer preferences with a clear sense of how the local business environment is evolving. Requirements include both research techniques relevant to China and people with the experience to draw out actionable customer insights.

Many multinationals have these capabilities, but unless they have been operating in China for some years, they may well lack the domestic-market knowledge or relationships needed to apply them effectively. The solution—building a true domestic Chinese presence rather than an outpost—sounds obvious, but it’s difficult to carry out without commitment from the top. Too many companies fail by using “fly over” management. But some multinationals appear to be investing the necessary resources; for example, we recently met (separately) with top executives of two big industrial companies who were being transferred from the West to run global R&D organizations from Shanghai. The idea is to be closer to Chinese customers and the network of institutions and universities from which multinationals source talent.

Retaining local talent

China’s universities graduate more than 10,000 science PhDs each year, and increasing numbers of Chinese scientists working overseas are returning home. Multinationals in particular are struggling to tap this inflow of researchers and managers. A recent survey by the executive-recruiting firm Heidrick & Struggles found that 77 percent of the senior executives from multinational companies responding say they have difficulty attracting managers in China, while 91 percent regard employee turnover as their top talent challenge.

Retention is more of an issue for multinationals than for domestic companies, but as big foreign players raise their game, so must local ones. Chinese companies, for example, excel at creating a community-like environment to build loyalty to the institution. That helps keep some employees in place when competing offers arise, but it may not always be enough.

Talented Chinese employees increasingly recognize the benefits of being associated with a well-known foreign brand and like the mentorship and training that foreign companies can provide. So multinationals that commit themselves to developing meaningful career paths for Chinese employees should have a chance in the growing fight with their Chinese competitors for R&D talent. Initiatives might include in-house training courses or apprenticeship programs, perhaps with local universities. General Motors sponsors projects in which professors and engineering departments at leading universities research issues of interest to the automaker. That helps it to develop closer relations with the institutions from which it recruits and to train students before they graduate.

Some multinationals energize Chinese engineers by shifting their roles from serving as capacity in a support of existing global programs to contributing significantly to new innovation thrusts, often aimed at the local market. This approach, increasingly common in the pharma industry, may hold lessons for other kinds of multinationals that have established R&D or innovation centers in China in recent years (read about AstraZeneca’s experience in “Three snapshots of Chinese innovation”). The keys to success include a clear objective— for instance, will activity support global programs or develop China-for-China innovations?—and a clear plan for attracting and retaining the talent needed to staff such centers. Too often, we visit impressive R&D facilities, stocked with the latest equipment, that are almost empty because staffing them has proved difficult.

Instilling a culture of risk taking

Failure is a required element of innovation, but it isn’t the norm in China, where a culture of obedience and adherence to rules prevails in most companies. Breaking or even bending them is not expected and rarely tolerated. To combat these attitudes, companies must find ways to make initiative taking more acceptable and better rewarded.

One approach we found, in a leading solar company, was to transfer risk from individual innovators to teams. Shared accountability and community support made increased risk taking and experimentation safer. The company has used these “innovation work groups” to develop everything from more efficient battery technology to new manufacturing processes. Team-based approaches also have proved effective for some multinationals trying to stimulate initiative taking (read about General Motors’ approach in “Three snapshots of Chinese innovation”).

How fast a culture of innovation takes off varies by industry. We see a much more rapid evolution toward the approach of Western companies in the way Chinese high-tech enterprises learn from their customers and how they apply that learning to create new products made for China (read a perspective on the evolution of its semiconductor sector in “Thee snapshots of Chinese innovation”). That approach is much less common at state-owned enterprises, since they are held back by hierarchical, benchmark-driven cultures.

Promoting collaboration

One area where multinationals currently have an edge is promoting collaboration and the internal collision of ideas, which can yield surprising new insights and business opportunities. In many Chinese companies, traditional organizational and cultural barriers inhibit such exchanges.

Although a lot of these companies have become more professional and adept at delivering products in large volumes, their ability to scale up an organization that can work collaboratively has not kept pace. Their rigorous, linear processes for bringing new products to market ensure rapid commercialization but create too many hand-offs where insights are lost and trade-offs for efficiency are promoted.

One Chinese consumer electronics company has repeatedly tried to improve the way it innovates. Senior management has called for new ideas and sponsored efforts to create new best-in-class processes, while junior engineers have designed high-quality prototypes. Yet the end result continues to be largely undifferentiated, incremental improvements. The biggest reason appears to be a lack of cross-company collaboration and a reliance on processes designed to build and reinforce scale in manufacturing. In effect, the technical and commercial sides of the business don’t cooperate in a way that would allow some potentially winning ideas to reach the market. As Chinese organizations mature, stories like this one may become rarer.

China hasn’t yet experienced a true innovation revolution. It will need time to evolve from a country of incremental innovation based on technology transfers to one where breakthrough innovation is common. The government will play a powerful role in that process, but ultimately it will be the actions of domestic companies and multinationals that dictate the pace of change—and determine who leads it.

All eyes are on China this November as the country prepares for the once in a decade leadership transition within the ruling Communist Party.

The world’s second biggest economy has undergone a massive transformation within the last 10 years. From rapid urbanization and economic growth to social and political development, China has marked many milestones and firsts in the past decade — highlighting its significance on the global stage.

With this in mind, we look at six major changes that China has undergone since the last leadership transition in 2002. Focusing on factors like economic development to changes in consumer behavior, we look at how big of an impact China’s transformation has had on the rest of the world.

Riding the wave of rapid economic expansion, China’s growth engine has remained strong over the past decade. China’s economy grew from being the 5th largest in the world in 2002 to 2nd only to the U.S. by 2010.

The country has seen an average annual gross domestic product (GDP) growth of 10.6 percent since the last leadership transition in November 2002. Yearly economic growth was in the double digits from 2003 to 2007 and hit a high of 14.2 percent in 2007 — levels not seen since the early 1990s. However, like the rest of the world, China was impacted by the global financial crisis in 2008 and saw its GDP fall to 9.6 percent that year. Since then, the superpower has been able to maintain strong economic growth of over 9 percent, but it continues to be plagued by fears of a hard landing. GDP in the second quarter of this year fell to 7.6 percent, hitting its slowest pace in three years.

Many economists now expect China’s annual GDP to fall below 8 percent in 2012, with even Beijing setting a target of 7.5 percent growth — marking China’s first drop to that level since 1999. Uncertainty over how the new leadership will deal with slowing growth is intensifying and several analysts have told CNBC that policymakers may be taking their eye off the ball when it comes to the economy to prepare for the once-a-decade leadership transition. The politics involved in the government change may be slowing the policymaking in China and deterring the government from making significant economic decisions, according to experts.

Rising incomes

National Bureau of Statistics China

Economic development has led to rising incomes in China as workers demand higher wages to cope with soaring living costs in major cities.

In a 10 year period, the per capita income of urban residents rose from $827 in 2001 to $3,711 in 2011, according to the National Bureau of Statistics of China. That’s a nearly 350 percent increase. China’s average minimum wage has been rising an average 12.5 percent annually from 2006 to 2010, and the government announced earlier this year that minimum wages should grow by an average of at least 13 percent in the five years to 2015.

Rising wages has become a major concern for local and international manufacturers betting on “cheap” Chinese labor for growth. Many are moving production inland to save on costs, while others are looking into alternative manufacturing hubs in Asia like Vietnam, the Philippines and Indonesia. For example, Apple supplier Foxconn, in the news recently for labor unrest at its Chinese factories, announced in August that it would invest $10 billion in Indonesia to tap into one of the cheapest labor forces in Asia.

Stocks Outperform in a Decade

Thomson Reuters

China’s battered stock market, which was down more than 20 percent in 2011, and is lower by nearly 6 percent so far this year, has made headlines recently for being the worst performing major equity market in Asia — a sharp contrast to China’s growth story.

Still, taking into account the total gains made over the past decade paints a more bullish picture. The Shanghai Composite index rose 35 percent from 2002 to 2011, far outperforming the U.S. benchmark S&P 500 which only rose 9 percent in the same period. But, despite the substantial 10-year gain, it hasn’t been all smooth sailing for Chinese equities. The Shanghai Composite fell about 65 percent to 2,016 in October 2008 during the global financial crisis from a peak level of 5,725 in September 2007. While stocks continued to gain ground up until August 2009, it has been in a steady decline since.

Despite the downtrend in the last three years, several analysts are still optimistic about a turnaround in Chinese equities on the growing possibility of more easing by the government to spur growth. Japanese brokerage Nomura predicted in July that Chinese stocks could climb as much as 20 percent by the first quarter of 2013 after having bottomed in early June. Meanwhile, the notable head of Goldman Sachs Asset Management — Jim O’Neill — said in September that Chinese equities present the “most attractive” investment opportunity in all of the BRIC markets.

Internet Explosion

China Internet Network Information Center

By sheer numbers, China is experiencing a technology boom unlike anywhere else in the world. Its internet population surpassed half a billion users in 2011 — making it by far the world’s biggest online market. That’s a more than 362 percent increase since 2005. Even then, the internet usage penetration remained at 38 percent in 2011, presenting further growth potential.

About four out of 10 Chinese use the internet, accounting for a total of 538 million users, according to state-run agency China Internet Network Information Center (CNNIC). That population is set to jump to 700 million users by 2015, according to the Boston Consulting Group (BCG), which is more than double the entire population of the U.S. The country’s fast growing online market provides a big opportunity for retailers and BCG predicts that China’s online retail sales will triple to more than $360 billion by 2015 to make it the world’s largest online retail market.

Smartphone makers are also looking to increase their presence in the country’s mobile phone market. Nearly 70 percent of China’s internet users connected to the web through their handsets in 2011, according to the CNNIC.

Mega Rich Get Richer

The Hurun Research Institute

China’s billionaire count has surged in the past decade, spurred on by the country’s rapid economic development.

In 2001, China had only one billionaire, but that number has jumped to 251 this year —according to the Shanghai based Hurun Report — making it second only to the U.S. in the world when it comes to most billionaires. Billionaires account for just 1.3 percent of wealth individuals with $30 million or more in China, but control nearly a quarter of the ultra-rich group’s wealth of $1.58 trillion, according to research firm Wealth-X. These billionaires are worth an average of almost $2.6 billion each.

China’s consumption and construction boom are two of the major drivers of wealth for the super-rich with a majority of billionaires counting on property as one of their main sources of wealth. The public listing of companies has also made business owners billionaires overnight. But recently, the stock market has also caused China’s billionaires to lose almost a third of their combined wealth with the benchmark Shanghai Composite falling 20 percent from August 2011 to July 2012, according to Wealth-X. In total, the population of China’s wealthy with assets worth $30 million and above shrank by 2.3 percent in the past year, while their combined wealth decreased nearly 7 percent to $1.6 trillion.

Consumption Boom

National Bureau of Statistics China

Consumer spending in China has seen double digit growth for a decade, creating a path for the country to become the world’s biggest consumer market by 2015, according to government authorities.

Its fast growing consumer class of about 130 million has given a big boost to markets from retail and housing to travel and other discretionary sectors. China’s consumer retail sales, for example, are expected to surpass $5 trillion in 2015, according to Commerce Minister Chen Deming. Rising incomes amid rapid urbanization are major reasons behind China’s consumption boom and the World Bank expects the growth to continue as income per capita climbs to more than triple to $16,000 by 2030 from about $5,000 now.

Businesses like carmakers, luxury retailers, and hotel chains have been flocking to the world’s second largest economy to target Chinese consumers. Italian fashion house Prada, for example, counts on China as its biggest market with 30 percent of its global sales in the fiscal year that ended in January 2012 coming from the country. The luxury retailer has 19 stores in China, but plans to open up to 15 more this year. The world’s largest premium carmaker BMW, meanwhile, increased sales of its flagship BMW brand in China by 55 percent in September compared to the previous year, while its Mini cars saw sales jump a whopping 121 percent in the same period.

But not all retailers have had a similar level of success in China. Home Depot, the world’s largest home improvement chain, struggled to win over Chinese shoppers with its U.S. style do-it-yourself model. The U.S retailer announced in September that it will close all seven of its big box stores to focus on specialty stores and e-commerce in China.

The U.S. is not the only superpower facing political change this week. China begins its 18th Communist Party Congress on Wednesday and party leaders will decide who will lead the world’s second biggest economy.

“This is an historic time to be watching China politically now,” says Nicholas Consonery, Asia analyst for Eurasia Group, a global political risk research and consulting firm. “The Communist Party, which has been in charge since 1949, is going to see a big transition in the entire leadership of the party.”

Consonery tells The Daily Ticker that the Party’s standing committee, which leads the country, will almost completely turn over and may even be reduced in size from nine to seven members. These individuals will likely run China for the next 10 years.

It’s expected that Xi Jinping, China’s vice president, will be named the new head of state and Li Kequiang, the current executive vice premier, will become the new premier. Although the changes will announced by Nov. 11, they won’t take effect until March 2013.

Consonery says the changes are wide and deep — the equivalent in the U.S. to a change in the presidency, the Joint Chiefs of Staff, the Supreme Court and the governorships of most or all the states, all at once.

“It’s not just change at the top of the party, but the whole party structure,” adds Consonery.

Related: China’s Slow Growth ‘Marks an End of an Era’ But No Hard Landing China’s new government will face many domestic challenges including a slowing economy, a growing middle class and increasing demands for political reform. China’s economy grew at a 7.4% annual rate in the third quarterits slowest since the first quarter of 2009.

China’s new leadership with also have to contend with an increasingly fraught relationship with the U.S. and its Asian neighbors.

The Obama Administration has been bringing more cases against China through the WTO, charging China with unfair trade practices.

Related: America vs. China: “Free Trade is Only for Friends,” Says Prof. D’Aveni “The U.S. is clearly headed in the direction of taking more forceful stances with China over trade and economic issues,” says Consonery.

In Asia, there’s a “growing level of concern about China’s rise on the part of many of its neighbors and a clear determination on the part of the U.S. to increase its engagement there,” says Consonery. China and Japan both claim ownership of the uninhabited Senkaku Islands, which are currently controlled by Japan.

Chinese surveillance ships have been seen sailing in the waters around the islands. On Tuesday the U.S. and Japan began an 11-day join military exercise in the area.

China’s economic juggernaut has been hobbled by Europe’s recession and America’s sluggish recovery. Export orders declined at the fastest pace in 42 months in September, manufacturing contracted for an 11th straight month and China’s purchasing managers’ index (PMI) fell to its lowest level in nearly two years.
Combined with the long-term underperformance of the Shanghai Composite, such lackluster data is giving rise to concern about a “hard landing” in China. Longtime China bears such as hedge fund manager Jim Chanos and Forbes’ columnist Gordon Chang have become more vocal lately — or at least have been given more of a hearing.
On Monday, the World Bank cut its outlook for East Asia, saying the China slowdown could intensify and last longer than currently anticipated. The World Bank cuts its outlook for Chinese growth to 7.7% in 2012 and 8.1% in 2013, down from 8.2% and 8.6%, respectively. A recent Reuters poll forecast China’s annual growth would ease to 7.4% in the third quarter, putting it on track for sub-8% growth for the first time in more than a decade.
Still, over 7% GDP is nothing to sneeze at and Richard D’Aveni, professor of strategic management at Dartmouth’s Tuck School of Business says reports of China’s imminent demise have been exaggerated.
Having just returned from China, D’Aveni believes the recent slowdown is a short-term concern and that China’s long-term prospects remain bright.
“Everybody’s apoplectic about slowing growth but they’re still growing five times faster than the U.S.,” he says. “No matter what happens, they are still sitting on trillions of dollars reserves and the country has little debt.”
Beyond that, D’Aveni is impressed with China’s ability to manage the transition from an export-led economy to one driven by domestic demand. China’s market is the world’s largest and rising incomes will continue to generate demand for goods and services; retail sales are up 14% this year in China, down from previous years but still robust.
Furthermore, he notes the ability of central bankers to successfully manage and direct the economy.
As part of efforts to support the economy, China’s central bank cut interest rates twice this summer and has lowered the level of cash it requires banks to hold as reserves three times since late 2011. In late September, the People’s Bank of China injected a record $57.9 billion into money markets, which helped spur a big rally in local stocks ahead of last week’s Golden Week celebration.
“The Chinese government has many more tools to manage a bubble than we do in the U.S. or than Japan had when their bubble burst,” D’Aveni says. “They have so much control over the economy they can make it work. You can’t count them out. They will stimulate their economy out of this situation.”
But don’t confuse, D’Aveni’s optimism about China with admiration for its state-sponsored model. His new book, Strategic Capitalism: The New Economic Strategy for Winning the Capitalist Cold War, he writes about the threat posed by China and offers recommendations for how the U.S. and other Western powers can address the challenge, as detailed in part two of the accompanying interview